Can the internet revolutionise finance in China?

Internet finance in China has developed rapidly over the past several years. Internet finance embraces a wide range of activities, including third-party payment, online lending, direct sales of funds, crowd-funding, online insurance and banking and digital money. Public sentiment towards internet finance has moved the full gamut from fever pitch to fear. What is the future of internet finance?

Optimists argue that internet finance represents a third type of financial intermediation, after direct and indirect financing, which could completely revamp traditional financial industries.

Others point out that internet finance is mainly a Chinese phenomenon and is a product of regulatory arbitrage, which could evaporate once financial regulations tighten to levels equivalent with those in advanced economies. From mid-2015, as internet finance grew and the associated risks escalated — evidenced by growing numbers of problematic peer-to-peer (P2P) lending platforms — these pessimistic assessments gained traction among financial industry practitioners, scholars and even government officials.

Qilun Wu, a famous financial commentator on Chinese microblogging website Weibo, has argued that P2P lending is a Ponzi scheme. Many share Wu’s opinion. But is this really the case?

The rise of internet finance in China has been triggered by at least three factors. First, repressive financial policy produces an undersupply of financial services, especially for small- and medium-sized enterprises (SMEs) and low-income households. This leaves a hole in the financial market. Second, regulator tolerance has provided space for internet finance to emerge and grow. And third, IT tools, especially mobile terminals and big data analysis, increasingly offer effective ways for internet finance to increase its efficiency and control financial risk.

A distinct advantage of internet finance over traditional finance is that it substantially reduces due-diligence costs. As a result, financial transactions that would otherwise be commercially unviable in the traditional financial industry are enabled. More importantly, the long-tail feature of internet technology implies that, once the system is established, the marginal cost of servicing additional customers is close to zero. So, the internet has a natural fit with the evolution of more inclusive finance in China. In this sense, internet finance is indeed a real innovation and not a passing bubble as some fear.

This suggests that internet finance has the potential to add real value to financial transactions, especially via enabling commercially profitable transactions from demand for credit that previously was commercially unviable. Whether this potential can turn into real business is dependent on several conditions, the most critical of which is the internet’s ability to continue to reduce information asymmetry for financial transactions.

For internet finance to work, institutional market participants need to have sufficient understanding of finance, access to internet channels, a quality dataset and data analysis capacities. Against these straightforward criteria, many practitioners of internet finance in China today are probably not ideally qualified. This, rather than the core of the industry itself, is why the internet finance industry is suffering from bubbles and scandal at present.

Internet finance in China fills an important gap in the market by extending financial services to customers who are insufficiently serviced by the traditional financial industry. And, it facilitates financial transactions in general by lowering costs and reducing risks through better use of customer analytics data — by reducing information asymmetry. On these two counts, internet finance offers genuine innovation.

If these features can be further improved and strengthened, internet finance should survive, especially as a form of more inclusive finance, whether or not regulations are tightened significantly. It is even possible that China is leading a new product cycle globally in this pioneering area.

As with any young but promising new industry, the risks are high for China’s internet finance sector. Many investors chase quick money through either blind optimism or Ponzi schemes. At the end of the 20th century, the United States also experienced a collapse of its internet bubble, but there was real and lasting innovation: a number of global leaders such as Google and Amazon rose from the ashes. At this stage, there are no guarantees that internet finance will even survive, as was the case with selective internet-based IT platforms 15 years ago.

To ensure the healthy development of internet finance, important conditions need to be met in at least three areas. The first requires there to be a set of ‘infrastructure’ facilities. At the minimum, this requires a network of mobile terminals or the ability to analyse available data, or both. Strictly speaking, big data still does not exist in China. The government may need to introduce a policy framework to both make useful data publicly accessible and safeguard individuals’ privacy. A credible and integrated credit reporting system for individuals and SMEs would also be valuable for internet finance credit allocation decisions.

The second condition concerns regulation of financial qualifications for industry participants. The essence of internet finance is the financial transaction. So it is vital for internet finance professionals to have a good understanding of finance, especially the related risks. A lot of problems in the internet finance sector were created by professionals who did not understand or respect basic financial rules and principles.

The third condition relates to a regulatory framework that strikes a balance between encouraging innovation and controlling risks. Internet finance is still finance, and financial transactions need to be appropriately regulated. Both too little and too much regulation could hinder the otherwise beneficial evolution of internet finance.

Yiping Huang, Yan Shen, Jingyi Wang and Feng Guo are research fellows at the Institute of Internet Finance, Peking University.